Keep calm and carry on

Low gilt yields mask UK election fears

Market prices are usually a pretty good guide to investor sentiment. But the superficial calm in UK bond markets isn't necessarily a sign of complete serenity about the May 7 national elections.

True, at 1.61 per cent, the yield on Britain's benchmark 10-year gilt is lower than it was at the start of the year, and not too far from record lows set on January 30. However, investors are far from phlegmatic about a ballot which is finely balanced, and could produce a minority government or a coalition which is potentially reliant on the Scottish National Party, which last year campaigned for separation from the UK.

One tell-tale sign of pre-election nerves is increasingly tepid demand at gilt auctions. On April 8, investors bid for only 1.19 times the amount of bonds on offer from the UK Debt Management Office. This so-called bid-to-cover ratio was the lowest since March 2009. Nor was this just a one-off. The average ratio for auctions so far this calendar year of 1.60 is almost a fifth below the 2014 average.

Another indicator is the behaviour of foreign investors, who are more footloose than many of their British counterparts. The proportion of gilts held by overseas investors fell to 24.7 per cent in the fourth quarter of 2014, the lowest since 2005, UK Debt Management Office data shows. Moreover, foreigners sold £13.7 billion of gilts in January and February, according to separate Bank of England statistics.

So why are gilt yields not rising? British pension funds and insurers, which need to match assets to liabilities, are taking up some of the slack. Domestic asset managers might also be willing to step into the gap left by overseas peers without demanding significantly higher yields. After all, gilts still offer a premium over most euro zone counterparts. Also, sterling-based investors don't need to worry about any post-election slump in the pound.

Of course, even domestic investors will become more exacting if the election leads to prolonged political uncertainty. In that case, it will become even more abundantly clear that the pre-election calm was an illusion.